Fundamental analysis is a term you may have come across in the course of your investing journey. One of the first questions many people ask after they find out you’re an investor is ‘do you do fundamental or technical analysis?’. Whilst we Fools don’t necessarily agree with that dichotomy, it still proves that an understanding of what is meant by fundamental analysis is very important.
What do we mean by ‘fundamental analysis’
When someone refers to ‘fundamental analysis’, they are describing how an investor values a company. At its core, fundamental analysis is about assessing the ‘fundamentals’ of a business in order to determine its value to the investor, and by extension what price an investor should buy or sell said business, if at all.
These fundamentals can be anything that tells us how much money is coming in and out of a company, whether that be external considerations like economic growth or inflation, or internal metrics such as a company’s revenue growth or profitability.
Fundamental analysts use this data to determine whether the price that is set for a company’s shares by the market is an accurate valuation for a business. They then use this assessment to decide whether a share is worth buying (i.e. the fundamentals tell the investor that the company is undervalued) or selling (the fundamentals indicate an overvaluation).
Fundamental analysis is often held up as an opposite to technical analysis, which instead uses share pricing charts and devices rather than ‘fundamentals’ to determine the trajectory of a company’s share price.
How fundamental analysis works
That all sounds very simple, but fundamental analysis is partly a game of probability. ‘How likely is it that a company can continue to grow revenue at x%’ or ‘how much of a market can this company capture’ are two common questions a fundamental analyst might ask.
Qualitative and quantitative analysis
A fundamental analyst might start a valuation process by looking at a company’s market capitalisation, its history and its place in the market it operates in. A logical progression would then bring in a company’s financial statistics, such as how much revenue it brings through the door and how much of this it keeps as earnings and profits. A thorough examination of the company’s income statement, balance sheet and cash flow statements are vital here. Then, the investor might look at how these numbers have been growing (or shrinking) over time. This is referred to as ‘quantitative analysis’.
After developing a deep understanding of these numbers, the fundamental analyst might then have a look at how the company is being valued by the market, perhaps contrasting its valuation against any competitors using the price-to-earnings (P/E) ratio.
Following this, an assessment of external factors that may affect the company might be considered. That might include what kind of industry the company is in (growing or declining), whether the company has a ‘moat’ or intrinsic competitive advantage (perhaps a powerful brand), or how external economic factors might affect its business (e.g. a cyclical company will be harder hit in an economic downturn). This is known as ‘qualitative analysis’.
If, at the end of this process, the investor decides a company is worth buying, they then have to consider why the market has come to a different conclusion and whether ‘going against the crowd’ is a good idea in this case. Of course, every investor who calls themselves a fundamental analyst will have a different process and even different investing outcomes. Fundamental analysis is a guidebook, not a rulebook.
When should investors use fundamental analysis?
We Fools think fundamental analysis is absolutely essential in making good long-term investing decisions. When you buy a share or shares, you are really buying pieces of ownership in a business. Any good business owner will tell you that understanding the nuts and bolts of ‘your’ company is of paramount importance to understanding its future (and thus what its share price is likely to do over the long-term).
If your neighbour asked you to go into business with them, wouldn’t you first like to have a look at what kind of business he or she is looking to build? You’d be asking questions like ‘how is this business going to make money?’ and ‘what’s the competition?’
Well, the same logic extends to buying ASX shares. Therefore, we think having a sound fundamental analysis process for ASX shares is a good idea for any aspiring investor. Almost all of the most successful investors, such as Warren Buffett, use a form of fundamental analysis. There’s a good reason why!